The Power of Opaque Selling

Some friends and I recently organized a trip to Las Vegas. We were able to find great hotel rates for Friday night, but published Saturday night rates were crazy expensive. So we turned to Priceline, and within minutes we had a 5-star hotel for Saturday, on the Strip, for a fraction of the lowest listed price.

Priceline, Hotwire and vacation packages from offline and online travel agencies can offer prices that are dramatically lower than published rates without cannibalizing revenue because they are opaque selling channels. Opaque selling makes some part of a purchase non-transparent to the consumer (such as which hotel, what time the flight will leave, what products you are buying) so that the probability of revenue cannibalization is dramatically reduced. While opaque selling creates incremental revenue for airlines, hotels and car rental companies, can it work in other industries?

Fukubukuro, a Japanese New Year’s Day tradition, puts opaque selling to work in shops across the country each year with retailers packaging an unknown collection of things into “lucky bags” and offering them at various prices. The idea is that the retail value of the bag is much greater than the price, but the catch is that you don’t know if you want what’s in it.

Just about every retailer in Japan participates in this tradition. While it started as a way to clear out last year’s inventory, it’s now as much about promoting retail shops as it is about opaque selling. Japanese friends of mine describe Fukubukuro much in the same way eBay (s ebay) fanatics describe bidding for an item — as a game-like addiction.

While the seller of a product or service would ideally like to charge the maximum price a buyer is willing to pay — the goal of price discrimination — the seller doesn’t actually know what that maximum is. And the buyer has no incentive to tell, as anyone who has haggled with a car salesman well knows.

So sellers create segmented offerings as a way to get at least some customers to pay more. For example, airlines offer first-class seats at a dramatically higher price per unit of space consumed — the buyer gets more space and the prestige of flying in first class and the airline gets an order of magnitude higher revenue per customer for the same flight — often 10x more.

Even with all of these techniques, the market clearing price for products often leaves a seller with excess inventory — open seats on a flight, for example. The marginal cost of that inventory is often so low that it is usually possible to sell it for a profit, but doing so means that people who would have bought the product at a higher price will now pay less and aggregate revenue will decrease. By selling a hotel room through a bundled vacation package a seller dramatically decreases the likelihood that she is cannibalizing her revenue — especially in fragmented markets.

The Opportunity

At the end of each day, many shops toss perishable items. Why not offer lucky bags? At the end of a season, many clothing retailers push their inventory to outlet stores under the assumption that forcing consumers to drive out of the way will prevent the cannibalization of sales, even though such outlets are increasingly located near major metropolitan areas. Why not find an opaque channel instead? The same thing goes for consumer electronics, video games, and so on. The Amazon.com (s amzn) Gold Box has daily deals — why not turn the Gold Box into the Amazon.com “lucky” box? It would offer consumers killer deals, it would be fun, and it would offer Amazon and its suppliers an opaque selling channel.

Fukubukuro aside, would opaque selling work outside of travel? I believe that it can. After all, the fundamental economic drivers of opaque selling in travel exist in many other industries. Less transparency isn’t always such a bad thing.

An interesting way to look at the concept of opaque pricing is in terms of the “credible commitment” factor:

Imagine you are running a business and a customer approaches you and proclaims the following:

“I am willing to pay $150 for your product, but I swear on my life that I am not willing to pay a dollar more. I know that one of your competitors is willing to sell me a similar product for $150, and if you refuse my offer, I will instead purchase your competitor’s product.”

Would you accept the offer? Even though the offer price of $150 would generate a profit from your product that you otherwise wouldn’t sell, you probably wouldn’t accept, because you have no reason to believe that the customer is telling the truth. If you were open to negotiating at all, you would hope that this is their first offer, and upon refusal, they would continue to raise it. In fact, if you did accept, you would effectively be training your customer to lie to you to get the better deal. Even if you knew the competitor next door was, in fact, selling a similar product at $150, you might hope that the customer places a premium value on your brand. In a normal buyer-seller relationship, as you pointed out, “the buyer has no incentive to tell, as anyone who has haggled with a car salesman well knows.”

Imagine, though, if you could go to two car salesman, discover their minimum price, and somehow convince them that you are not willing to pay a dollar more (and, knowing each salesman’s minimum price, you really wouldn’t pay more to either of the two). This is where the credible commitment factor comes into play. If the supplier has good reason to believe that you are offering your maximum price, it is typically in their best interest to accept (assuming they are covering fixed costs and generating more profit then the next best alternative use of the unit of inventory).

Hotwire is not selling hotel rooms, air tickets or car rentals. At such steep discounts off of full price, the hotels, airlines and rental agencies are perfectly capable of selling their excess inventory directly to the customer without paying Hotwire commission.

Hotwire is instead selling “proof of credible commitment” – commitment on the customer’s part that if you refuse their offer, they will not be offering you a higher price. Hotwire’s business model creates a rate fence around customers that are price sensitive and brand insensitive within a given geographic area and quality tier.

As you mentioned, “sellers create segmented offerings as a way to get at least some customers to pay more”. In between the price insensitive, brand sensitive customer that is willing to pay full price for their preferred brand and the price sensitive, brand insensitive customer, there is a market of customers with a brand preference that are not able or willing to pay full price.

Using the credible commitment model from Hotwire, is there a way to reach this market? What about this: the customer commits to purchasing the product (in the given geographic range and quality tier) from the supplier with the lowest ask price, just like the Hotwire model. After entering their credit card information and agreeing to a non-refundable purchase, they are prompted with the opportunity to bid on the brand of their choice before the winning supplier is divulged, with two possible outcomes: the bid for the desired brand will be accepted and the customer pays a premium over the opaque price but a discount to the full, transparent price, or the bid is denied and the customer is required to purchase the product from the supplier with the lowest ask price in the opaque model.

The fundamental “credible commitment” factor still exists as the customer guarantees that if their offer to their preferred brand is refused, they are guaranteeing to purchase from the competitor. What are the flaws in this concept?

The thing that seems weird at first about “opaque selling” is that it is about artificially DECREASING the value of a product to a customer (by preventing the customer from knowing exactly what he or she is paying for). But this is actually common in many industry, and opacity is only one way in which value can be decreased.

There are many cases in which a seller with excess inventory will say, in effect, “OK, I’ll sell this good or service for less than the price I’d like to, but to avoid driving down the product’s usual price I will actually damage or degrade it in some way first.”

One such tactic is “opaque selling,” you get exactly the same hotel room as you would have gotten at a higher price, but it’s artificially devalued because you don’t know if (for example) it’s convenient to a meeting you’re attending or to public transportation. Another is “crippleware,” in which you get a piece of electronic equipment or software with features artificially turned off. (Often, they can be turned back on by paying the difference between the “crippled” price and the full price, and receiving a code which activates the features.)

The problem with such schemes is that they only work in the absence of competition. If there’s real competition, the price of the undegraded product WILL be driven down as sellers compete for those last few customers. On the other hand, if there are multiple sellers with product available and they ALL engage in selling of degraded products rather than simply lowering their prices, it’s a form of tacit collusion to keep prices high.

For some sellers it might not be right. But for many others it is working very well. And it’s not about greed, but rather return on investment / productivity. It makes absolutely no sense to let a seat, room, or food go to waste. In my book, such an outcome is far worse than finding a way to generate incremental income WHILE serving customers at an accessible price.

why do I always see hairbrained ideas here … opaque selling or whatever you call it is not a sustainable model. Just like outlet stores were not sustainable.

Over time, price pressure would always set in, for the hotels it is get money now but suffer later. Any five star hotel wants to attract a certain kind of clientele, but with opaque selling the hotel attracts some people it does not want to and that drives down the price people with money are willing to pay for that item.

A lot of brands that tried price discrimination are pulling back and focusing on there core consumers, there is no need to be greedy.

Mike very interesting insight – and I agree that opaque buying is a product of the future – and can be transferred to the purchase of advertising – either on radio, print, TV (cable and cat. included) as well as web. In a way I see Google’s Adsense breaking the mould of traditional buying – including their new TV buying program and expandng on that concept to print, radio and outdoor.

Perhaps in the future we will see the same sort of opaque ‘lucky bag’ buying for advertisers – given a demographic, and a geographical region – after all the FCC has broken down the ownership rules and now we have conglomerates like Clear Channel; CBS/Infinity/Viacom; Univision/Entravision et al..with Radio and TV Stations and electronic outdoor – and advertising way down.

This ‘lucky bag’ approach – just upload your Mpeg .AVi or JPEG file to an FTP server and specify the demographics / pyschographics / ethnicity, of the audience you want to reach – and enter a price you want to pay – then see what you get in a combination of advertising.

I think you could use this approach for many other industry segments where you have excess capacity that is perishable (hotel rooms, flights, food, electronics, ad space, and so on). I don’t know of anyone doing these sort of things, but I didn’t look that hard…

Like everything in business, opaque selling might be a good idea until someone uses it as an excuse to screw consumers. Sure they might not be able to use it that way for long but that doesn’t stop people from getting screwed by a lot of different vendors.

That being said, it could work better in B2B types of settings more than B2C. For instance, I could see it working in a system where multiple businesses bid on someone’s order for widgets or whatever and the lowest qualified bid wins or something…similar to those exchanges that cropped up at the turn of the century.

On the B2C front, it could be a way for consumers to get access to fashions (outlet style) without revealing the house that created it right away. Could be an interesting model and a revenue source that doesn’t necessarily lower the value of the label.

Opaque selling totally works in other industries. Even the public sector has jumped in.

Last week, I learned that a new highway in Houston now offers dynamic toll pricing for the fast lane depending on demand at at any given current time. The Easy Pass system detects how many cars are in the fast lane and presents a price to new entrants accordingly.

Love the idea of congestion pricing, something that won William Vickrey the Nobel prize in economics (http://www.vtpi.org/vickrey.htm). I agree with you that it could be more broadly used to improve the productivity of assets without further investment.

My point on opaque pricing was a bit different — it is that opaque channels may offer sellers the opportunity to have their cake and eat it too. That is, that they can find the market clearing price as they already do and leverage another channel that will have minimal cannibalization of revenue, as has been done effectively in the travel industry.

When you go to the Astrance restaurant in Paris, there is only one menu, and you don’t know the dishes when you order. Also, the menu is (slightly) different for the different tables, so you can only guess what you will get by looking at the other guests.

Last time I went to dinner there (and the first time since the chef has adopted this formula) was one of my all time favorite meals ever.